Bumpier ride ahead for the quarterly profits of Canada’s biggest banks

Share

Prepare yourself: Canada's biggest banks will likely report bumpier quarterly profits from now on, but not because of a housing implosion, new competition or oncoming recession.

Instead, the source of this expected profit volatility is a new accounting standard that was adopted this month by the Big Six banks, at the start of their fiscal first quarter of 2018.

Okay, new accounting might sound like an eye-glazing concern for investors who quite rightly prefer to focus on the big banks' stellar record of generating strong long-term returns and rising dividends.

But the new approach to bean counting could rattle some nerves if you're unprepared for the results, because banks must now recognize potential loan losses, in the form of provisions, far faster than they used to.

"Credit provisioning is already the most volatile line on a bank's income statement and it is now set to react earlier and more severely to changing economic conditions," Robert Sedran, an analyst at CIBC World Markets, said in a recent note.

International Financial Reporting Standard 9, or IFRS 9, changes the way banks recognize loan losses. It addresses concerns that date back to the financial crisis of 2008 and 2009, which ushered in the Great Recession and led to enormous losses among many global financial firms.

Banks were inconsistent in the way they provisioned for credit losses, and when, leading to some frustration among observers and regulators.

You could see similar levels of frustration more recently, when the price of crude oil plummeted between 2014 and 2016, raising concerns among investors that energy companies would default on their bank loans and carve big holes in bank profits. In response to falling oil prices, the Big Six raised their provisions for credit losses (PCLs) but did so at their own pace, which generally lagged the provisions booked by their U.S. peers.

According to Mr. Sedran, the financial impact of weak oil prices, in the form of rising bank PCLs, didn't show up until the price of oil had hit a 12-year low in the first quarter of 2016. PCLs continued to rise after the price of oil had begun to recover.

This delayed reaction baffled some analysts, who suggested that Canadian banks were being far too optimistic about the potential impact on their loan books. Investors were no doubt confused as well: Canadian bank stocks fell an average of 22 per cent over this two-year period, reflecting uncertainty.

If such a collapse in oil prices were repeated under IFRS 9, the effect on the banks would look different. Mr. Sedran expects that banks would start provisioning for credit losses four quarters earlier, and would probably provision more.

"We conclude that provisioning, and likely share price reaction, for the Canadian banks would likely have been more severe during the energy downturn," Mr. Sedran said.

Of course, the operating conditions are very good for the banks right now. Economic activity is strong, the housing market is stable, loan losses are low and interest rates have been rising – and bank stocks are near record highs.

According to Darko Mihelic, an analyst at RBC Dominion Securities, this backdrop offers an ideal time to adopt the new accounting standards because the immediate impact won't be severe.

Some banks may have to set aside larger reserves, which will reduce book values (and raise one measure of valuation), but the analyst doesn't expect any major shifts.

The accounting changes, though, will show up when something goes wrong.

"When the economic outlook and underlying credit quality deteriorates, this may result in higher PCL volatility, similar to that observed for U.S. banks," Mr. Mihelic said in a note.

As well, he believes bank valuations may become more sensitive to economic indicators, since these indicators will now have an immediate impact on provisioning for losses under the new accounting standard.

Mr. Mihelic pointed out, for example, that Canadian bank stocks have traditionally been less sensitive than U.S. banks to changes in the unemployment rate. That could change.

Canadian bank stocks will still be great long-term investments. But the ride might not be quite as smooth.